to raid or not to raid the IRA ?

August 29, 2008

fwp

for the past month or several weeks now, i have been preoccupied by the following question:

to raid or not to raid my individual retirement account (IRA) to pay off some of my debts?

ah yes, this is a hot topic: ask anyone savvy or attentive to personal finance, and s/he will tel you “NO! don’t do it!!” without hesitation.

the immediate reasons that come to mind for discouraging you from touching your retirement assets:

you’re saving the money for later, when you’re old and tired and want to stop working — not for use now!
if it’s a 401(k) or say a simple IRA type of retirement account sponsored by your employer, contributions are tax-free, made before you are taxed on your paycheck
you’d lose out on the beauty of compound interest, where your money is working for you by earning more money just by sitting aside invested and essentially untouched
upon withdrawal, your brokerage will withhold 20% of the amount requested for federal taxes before you even receive any of the money
once you take out an amount before the age of 59 1/2, you will most likely incur a 10% penalty fee of the gross amount requested for taking out funds too early if you do not repay/return this within a given time frame

i’ve been thinking long and hard about these disadvantages. i even sat down and calculated the approximate amounts of what i would lose in terms of my retirement savings versus what i would lose via debt interest to compare numbers objectively. the loss came out somewhere in the hundreds, i believe — not exactly monumental. that aside, there was one thing that was difficult not to consider: my peace of mind.

this reminds me of GRS blog’s post i read recently on how to pay off one’s various debts with a method called the “debt snowball” approach. the classic advice is to start with the debt with the highest interest rate first, focusing primarily on putting in as much money as you can towards that, with minimum payments for any others. but the author brought up a very important point that i agree with immensely: that we as humans are emotional, and in order to be motivated and receive positive feedback, the better approach would be to pay off the smallest balances first regardless of interest rates, thereby reaping the benefits from the satisfaction of seeing immediate progress. he wrote:

instead of attacking high-interest rate debts first, you attack low-balance debts first. Why? Because you’ll get the psychological lift of pinging debts off in rapid succession.

on a similar note, i think of my current situation. i am indeed emotional. i am distracted by my debts and am uncomfortable about the money i am paying with a high interest rate. this may be a source of constant worry at least in my subconscious mind if i do not address it more effectively than merely putting in ‘as much as i can’ every month towards the payments. this wouldn’t be optimal for my mental well-being. i have the alternative to dip into my retirement savings for a little bit to pay off my loans. why not take care of this debt as much as i can now with an amount i feel comfortable extracting from my IRA?

but then i am confronted by the points above on why i should not raid my IRA.

i have two main sources of remaining debt at the moment:

college loans in the form of federal student aid — $10,848.93% at 3.960% to 4.760% interest
a personal loan from a credit service (this covered some education expenses, plus miscellaneous consumer debt over the years transferred from credit card balances) — $8,000 at 15.99%

i have two retirement savings accounts at the moment:

a simple IRA with t rowe price through my current employer — $2,713.39 (relatively new job)
a rollover IRA at t rowe price as a result of a 401(k) with new york life from a previous employer — $21,479.40

since the latter account is no longer a 401(k), unfortunately i can not merely take out a temporary personal loan from myself.

i printed out t rowe price’s ira distribution forms, all ready on my desk to fill out and to send in. they’ve been sitting there for at least a week.

what will i do? i am in a conundrum indeed.

what do you think? what would you do in my situation? how much would you take out?

ira

14 Responses

Welcome to a mid-September Carnival of Debt Reduction | Mighty Bargain Hunter • September 15, 2008 @5:01 am

[...] Financial Wellness Project has debated long and hard about whether or not to raid his retirement account to pay off debt. These are always tough questions. The cost of early withdrawal from a retirement [...]
woohoo! it’s monday and i’ve been included.. » the financial wellness project » because money doesn’t own you — YOU own money! • September 15, 2008 @12:27 pm

[...] to raid or not to raid the IRA ? [...]
b • September 15, 2008 @6:48 pm

You’re paying over $106/month for that $8K loan….Think about saving that $106 per month starting NOW. I say pay off the 8K balance now using funds from the IRA. Stretch yourself a bit maybe by only pulling $7K out of your IRA and try to come up with the rest of the payoff from other, non-qualified funds. Once you see the end of that debt being so close at hand, this may be much easier and more satisfying.
b • September 15, 2008 @6:55 pm

I’d hang on to that student loan as its a relatively low rate: just pay it out at the speed of minimum payments. The only option I would entertain there is to “pay it off” using one of those balance transfer offers for credit cards…sometimes you can find them for good fixed rates (I have a couple fixed at 2.99% until paid off) with low/no transfer fees. This can be done by setting up a “balance transfer” to a card that has no/low balance. In a few weeks, the card that was overpaid via the “balance transfer” will send you a check for the credit balance amount (usually only upon request). I’ve done this many times. I use the funds for investments that make better rates than that 2.99% I pay for the money (I guess that’s a bit like buying stocks on margin).
NtJS • September 16, 2008 @9:36 am

This is something that many folks consider when in your situation, and therefor is worth discussing - in spite of the instant “don’t do it!!” response.

“i think of my current situation. i am indeed emotional. i am distracted by my debts and am uncomfortable about the money i am paying with a high interest rate.”

That speaks volumes. Many people who have not been where you are, or where we were, like to reduce it all to math. It’s not all about math - we are not machines. Interest rates and penalties aside. Let’s say you did clean out the Simple IRA. What have you really accomplished? You didn’t improve your situation - you’ve simply moved the debt around. Sure, sure, you’ve reduced the amount being paid in interest, blah, blah, blah. Great. A small win. Not a significant one. Minuscule. It wouldn’t even take one of the debt’s off the books.

“there was one thing that was difficult not to consider: my peace of mind.”

There you go. It’s right there. It’s more ‘personal’ than it is ‘finance’. Take the paper’s and run them through the shredder. You’ll get there. There is not magic pill, and this certainly isn’t it.

cheers!
Troy • September 18, 2008 @1:29 pm

You are making this way too complicated.

Take all of your “disadvantages” and burn them. They are not disadvatages. The only disadvantage you should concern yourself with is the 10% early withdrawal penalty.

Follw me here:

Saving for later? So. You can save more for later without the debt

Contributions are tax free? of course they are, that is why there is the penalty and taxes. That is because you never paid taxes on them in the first place, and at some point in time you will HAVE to pay taxes on them. This is about timing, not taxes.

Compound interest: I hear this alot. so what. There is zero difference between earning interest and paying interest on a similar amount. You have a 8,000 debt, and $8,000 asset. They wash. The asset compunts positively. The debt compounds negatively (that is where the payment comes from). The argument that you are missing out on compounding interest from an asset is offset by the interest you pay on the liability. so…….

Your financial portion of the decision should be calculated on which action has the lower effective interest rate. Paying off a nearly 16% loan with money that averages 8-10 after tax is smart.

Then you must factor in the 10% penalty. Is it worth $800 to you to have that debt gone. if it is, pay it. If not, dont.

As far as having to pay taxes on the withdrawal…you have to pay taxes on all the moeny you make and as I said before you will have to pay taxes on the money in your IRA at some point in time also. So what. If your employer gave you an $8,000 raise, would you decline it because you have to pay taxes on it. NO.

Like I said, your decision is actually quite easy. IS IT WORTH THE 10% PENALTY TO RID YOUR LIFE OF THE DEBT FOREVER. Answer that question, and go with it. Forget the rest of the “factors” They are not factors, they are noise.
fwp • September 30, 2008 @11:24 pm

@b
2.99% sounds like a great deal! and i thought that my college loans’ interest rates were good..

that’s an interesting idea about balance-transferring the college loans for a while (and also potentially investing any credit elsewhere). i’d like to revisit that idea once i take care of my consumer debt balance.

i like your thinking on taking out not quite enough from my ira to pay off most of the balance — and then paying off the remaining via other methods to see the light at the end of the tunnel and experience the sense of satisfaction from paying off one’s debt.

@ntjs
thanks so much for your feedback!

i agree that there is no magic pill, and you bring up many good points.

however, you mentioned, “you’ve simply moved the debt around. Sure, sure, you’ve reduced the amount being paid in interest, blah, blah, blah. Great. A small win. Not a significant one. Minuscule. It wouldn’t even take one of the debt’s off the books.” but wouldn’t taking money from my ira be taking my consumer debt ‘off the books’? or perhaps you mean this in a different way than i am interpreting. also, would i really be ‘moving debt around’ ? with my retirement assets, i would be paying off the debt, so technically, there would no longer be any debt to be had here.. or perhaps you mean because i would ‘owe’ myself money that i would need to replenish after raiding my own savings?

@troy
you are right about the fact that i would have to pay taxes on the money at some point, either now or later anyways. you also bring up other great points — thank you so much for taking the time to reflect on this post with me.

yes, it would be worth the 10% penalty to get rid of the consumer debt. $800 (or less now) is not much compared to my potential peace of mind.
fwp • September 30, 2008 @11:31 pm

an update:

at this time i am in the process of making use of a new card’s 0% balance transfer to carry my consumer debt for 6 billing cycles while i pay off the ‘principal’. the plan:

1. move $6400 +/- balance transfer to credit card account
2. divide this by 6 — i would pay $1066.67 monthly
3. at the end of the 6 months/billing cycles (march) if i have any balance remaining (possibly from not being able to pay exactly 1066.67 every month), i pull money to pay for that from my IRA’s prime reserve money market fund account.
4. by april, i will have paid off my consumer debt with a combination of upcoming income and possibly a bit of retirement savings.
Hot Link » Blog Archive » Welcome to a mid-September Carnival of Debt Reduction • October 7, 2008 @2:36 am

[...] Financial Wellness Project has debated long and hard about whether or not to raid her retirement account to pay off debt. These are always tough questions. The cost of early withdrawal from a retirement account is [...]
the financial wellness project » Blog Archive » working with the universe to become debt-free • October 16, 2008 @3:33 pm

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